Financial frictions and policy cooperation: A case with monopolistic banking and staggered loan contracts

Do financial frictions call for cross-border policy cooperation? This paper investigates the implications of financial frictions in the form of staggered loan contracts supplied by monopolistic banks, for monetary policy. Using the linear quadratic (LQ) framework, we show that policy cooperation yields long-run gains in addition to gains from stabilizing inefficient fluctuations over the business cycle, as usually found in models with price rigidities. The Ramsey optimal steady states differ between cooperation and noncooperation. Such gains from cooperation arise irrespective of capital account liberalization.